The Importance of Due Diligence when buying a Franchise

This article was written by Mark Sherry and was first published in the Business Franchise Australia and New Zealand Magazine, and has been reviewed and updated in April 2020.

Background

Every now and then a piece of research is completed which makes you stop and think. The Asia Pacific Centre for Franchising Excellence, which is based at Griffith University in New South Wales, and the University of New South Wales School of Taxation and Business Law, recently published a report on how prospective business owners viewed due diligence. Rather worryingly, the study found that a significant percentage of people purchasing a franchise or small business did not undertake a proper due diligence investigation before committing to their purchase. In fact, many of them admitted to not understanding the term “due diligence” at all and many others, when questioned, gave definitions of “due diligence” that were significantly off point.

So what is due diligence? Due diligence is the comprehensive review of a business that a potential buyer undertakes to establish its commercial prospects. It also involves the weighing up of the risks that the business faces and then making a considered opinion on whether to commit to the purchase or not.

In Australia franchise legislation is drafted to strongly encourage franchisee’s to complete due diligence investigations prior to confirming their purchase. They are required to seek professional advice, normally from a lawyer and an accountant, or specifically waive their right to do so. Small businesses that are not franchised are not covered by this protection and the study found that in the case of such businesses that many transactions proceeded without a proper due diligence exercise being undertaken.

In New Zealand there is no franchise specific legislation that requires due diligence to be undertaken. However, franchise systems that voluntarily subscribe to the protocols produced by the Franchise Association of New Zealand do tend to have a requirement that franchisee’s either obtain or waive due diligence advice from lawyers and accountants.

Important Aspects of Due Diligence

First and foremost, when commencing a due diligence investigation on a franchise, a thorough review of the franchise agreement and the disclosure document is recommended. It is extremely important for a franchisee to understand various matters including how the fee and payment structures work, what their obligations are under the franchise system and what restraint of trade and exit obligations they may be subject to if the franchise either expires or it is sold or otherwise terminated. They need to know that there is an exit strategy that they can live with when the franchise does come to an end. Often this is overlooked and it can create real issues in the future.

It is often a lawyer who will look at the franchise agreement for a buyer. They will interpret particular issues and provide an explanation to the purchaser. In this regard not all lawyers are created equal, as there are often hidden issues in a franchise agreement that a lawyer inexperienced in franchise matters may not pick up. Further, in many instances it is equally important to understand what is not contained in a franchise agreement - things that an experienced franchise lawyer would often expect to see included. Omissions of important terms can be even more important than understanding the terms that are included.

From a financial perspective it is equally beneficial to include in the due diligence process an accountant experienced in understanding franchise systems. They will more easily grasp the implications of matters such as ongoing royalty payments, marketing contributions, transfer fees, and other payments that are peculiar to franchises and which need to be factored into cash flow projections and profitability analysis. In many instances buyers will go to their current accountant or lawyer rather than seeking out appropriate experts that could provide them with better advice. This can be to their detriment given that franchising has its own peculiarities.

Another aspect of due diligence that is extremely beneficial for a buyer is to make contact with franchisees that are already operating within the system. These people have already been through the process that the buyer is embarking on, and they are able to provide experienced viewpoints on how the franchise system works and how profitable it actually is. They will also have an opinion on how well the franchisor runs the system and supports the franchisees. Obviously a buyer needs to be wary of existing franchisees who are “cheerleaders” or those who hold extremely jaundiced views against the franchise system due to a dispute they may have had with a franchisor. Therefore it is important to approach a reasonable number of franchisees (if possible) to get a balanced view of how well the system really works.

An aspect of due diligence process that is often overlooked is a critical analysis of a buyer’s own suitability to become a franchisee. Being a franchisee requires a unique balance. On the one hand a buyer needs to have the right qualities to run a successful business, which can involve everything from managing staff, to marketing and control of finances. Equally however, the person cannot be too entrepreneurial as they must at all times follow their obligations under the franchise system and not be seen to be doing their own thing even if they think it would improve their business or make their life easier. This can be a difficult mix to achieve for some people, but it is important to understand this balance because some people are not suited to becoming franchisees simply because they are too independent and entrepreneurial.

Where an existing business is being purchased it is very important to complete a thorough review on matters affecting it. This investigation will involve matters such as a review of leases of premises, employment contracts for employees, ongoing supply contracts with major customers and suppliers, and a review of the financial accounts to assess the level of profitability and whether the price being paid is reasonable. It is also important to note that this part of the investigation can involve finding out what local authority consents may be required before a business can be operated legally. There are many franchises that are in the food and beverage industry, and these will require food licences and liquor licences. Similarly, businesses such as hairdressers, another common type of franchise system, will often require health licences for their premises too.

Finally, when completing a due diligence investigation, it would be remiss not to review finance and working capital needs. As already mentioned, advice needs to be taken from an accountant who can assist with a review of the existing books. They will also help prepare cash flow projections for the business moving forward. If money is being borrowed for the acquisition of the franchise it is useful to know that many banks have franchise focussed teams that are able to assist with the financing of the purchase. Some banks have preferred franchise systems that they are willing to back because they know the system, they trust the skill of the franchisor, and they understand the profitability that an individual franchise operation can achieve. If a franchise system has a particular relationship with one or two banks it would be worth speaking with those banking teams during the due diligence period.

Summary

It is important that a purchaser does not get caught up in the emotion of acquiring a business, or alternatively that they become so cost conscious at the due diligence phase, that they do not take appropriate advice. Often the best dollar that a buyer can spend, but the most difficult message to receive, comes from the advisor who with good reason convinces a prospective purchaser not to proceed with a transaction that has potential future issues. While there is an upfront cost in going through the process, the buyer has managed to avoid buying into a problem. The money is therefore not wasted at all. When it comes to acquiring a franchise it is important to remember the old adage that “business is business”. Sound and logical decisions need to be made based on proper research and advice. If that occurs it is much more likely that any franchise acquired will end up being profitable for the buyer whilst at the same time giving them a level of enjoyment and satisfaction that they have been looking for.

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